Risks to the EU from a US-China Trade Agreement

After the United States imposed $250billion of tariffs on Chinese goods based on its determination, under U.S. Section 301 of the Trade Act of 1974, that China had violated trade agreements with the U.S. and WTO rules, China retaliated with $160 billion of its own tariffs. The world’s two largest economies entered bilateral negotiations in December, 2018 for a trade agreement to resolve their differences. Such an agreement poses serious risks to the EU, both in regard to the general U.S. approach and with respect to specific measures regarding subsidies, state-owned enterprises (SOE’s), forced technology transfers and enforcement by snap-back tariffs.

The time is no longer distant when China will succeed the U.S. as the world’s largest economy. While leverage in WTO negotiations related to that position is difficult to measure, the U.S. administration says it is focused on changing Chinese behavior, and, one might add, while it has the opportunity to do so. This Administration’s preference for a unilateral over multilateral approach makes that timeframe even shorter.

The EU policy to seek reform of WTO rules to cope with China seems ‘too slow’ to U.S. trade policymakers and negotiators. They ask, “Given the Doha experience, when would new rules come into force? If not this year, what do we do in the interim. What is the EU perception of what we cannot do now? Must all of those things go into the ‘rules basket’?”

Of course it is entirely natural that countries with limited leverage in the WTO community– the vast majority of all trading nations– rely on the rules. Steps which erode the force of those rules are distinctly not in the interest of those who depend upon them. A US-China agreement to raise, abstain from raising or lower their tariffs will have a profound effect on the EU and others and will be done outside the WTO context. Unless that agreement covers ‘substantially all trade’ between the US and China under the widely invoked WTO authority for free trade agreements (Article 24) and is open to other nations who undertake the same obligations, it will violate the basic WTO building block of most favored nation (MFN) treatment.

But it is unlikely the coverage of a deal will approach the FTA standard. In any case, the parties will not put the deal under the WTO chapeau where it would be vulnerable to challenge by the EU and others, particularly given USTR’s dislike of WTO dispute settlement. This means difficult US-EU negotiations will be required after a deal is concluded to adjust the equilibrium.

Subsidies and State-Owned Enterprises (SOE’s)

Beyond tariffs, consider the case of Chinese subsidies and SOE’s. These practices embody the most direct and distortive deviation from the open market system on which the global economy and the WTO/GATT rulebook have been based. Their extent is unprecedented: $350billion of subsidies to ten leading industries of the future, e.g. robotics, electric vehicles, EV batteries, advanced computers and mobile devices, all part of the “Made in China 2025” program. The Chinese beneficiaries are for the most part SOE’s and the program specifies their intended domestic market shares. For obvious reasons, U.S. companies and industries around the world clamor for brakes on such subsidies. It is not yet clear to what extent the US and China can agree on restraints, particularly when Xi Jinping has given high priority and increasing support to the state-owned portion of the economy. But some of the possibilities underscore risks to the EU.

If the U.S. and China agree on measures to enhance transparency of subsidies (e.g. disclosure of new programs) and of SOE’s (e.g. amount of subsidies received, specific facts about government control), and the parties do not take steps to ensure other nations have the benefit of such reforms, the result would be two separate subsidy regimes: one bilateral and the other WTO/multilateral. This could be avoided if the parties made their reforms part of the existing WTO Code on Subsidies and Countervailing Measures (SCM). Then the EU and others might happily free ride on such reforms, rather than challenge them. But these two juggernauts are not likely to do so.

A more difficult case for the EU arises from reform of China’s subsidies to ‘zombie’ companies that are uncreditworthy or insolvent (e.g. steel makers), a goal highly prized by the U.S. China’s excess capacity to manufacture steel now exceeds the entire annual capacity of the U.S. industry. To comply with the WTO, the U.S. and China would have to add such reforms to their tariff schedules. These measures would raise defensive concerns in the EU and other countries where ‘state aids’ are a long-standing and legally recognized practice (e.g. Lisbon Treaty Article 345.)

If the EU classifies the US-China agreement as contrary to WTO rules, it could not both free ride to enjoy benefits of the transparency reforms noted above and challenge the “zombie” company reforms. But since the U.S. and China will not align any agreement with the WTO—particularly given USTR’s highly negative view of WTO dispute settlement, the EU would stand outside the agreement on both the plus and minus sides, absent post-deal negotiations to re-adjust the relevant equities.

Forced Technology Transfers

The US is suggesting the bilateral agreement include clauses related to tech transfers from the investment chapter of USMCA (NAFTA 2.0). These clauses prohibit requiring joint ventures as a condition of investment and equity caps unless specifically negotiated. Would the EU support such measures with potential benefits for EU investors? Similar provisions are already in the EU-Canada CETA and may also appear in the EU-Japan understanding on investment to supplement their Economic Partnership Agreement.

In response to external pressures, China is now amending its foreign investment law. The U.S. wants China to narrow the areas now fenced off from foreign investment such as finance, telecom, the “cloud,” ICT and express delivery services. This would presumably be done on an MFN basis. Wouldn’t the EU want the benefit of such changes? Isn’t this an example of the U.S. ‘allocating” its leverage to the benefit of the EU as some Commission officials encourage the U.S. to do?

More broadly, Washington seeks new ways to enforce Chinese promises. This U.S. is proposing methods that go beyond current rules in a “WTO PLUS” fashion. The EU will have to weigh the precedential value of China accepting such enforcement procedures compared to its adherence to a rule-based system, including its own initiation of a dispute settlement case on forced tech transfers with China last year.

Snap-Back Tariffs for Enforcement

In case of perceived violation of the terms of a US-China agreement, a strong enforcement tool under discussion is a return or ‘snap back’ to the U.S. (or Chinese) tariff levels that provoked this trade war. Indeed, for many months US negotiators proposed the unilateral right to enforce the deal in this way. After vigorous Chinese insistence on reciprocal enforcement rights, the U.S. has backed off and the enforcement issue remains hotly contested. Compromise will be difficult for the U.S. given the prevailing US view China has gamed the system in its favor at U.S. expense.

Ordinarily, tariff snap-backs return to MFN levels after review by a WTO dispute settlement panel or, in some FTA’s, including EU FTA’s, determination by a neutral third party outside the WTO. Thus far there is no sign of a role for a third party. Rather, it appears to date the world’s two biggest economies will adjust their tariffs in case of dispute with no outside input and with enormous impact on the EU and other trading nations.

How will the EU respond? EU policy is to respect the multilateral rules and expect its trade partners to do the same. But in this case such respect appears a dim prospect. Some at USTR, aware of the concern, say there will be a post-agreement US-EU negotiation for a sensible solution. Recent US-EU differences on trade and the enormous impact on the global economy of a US-China deal suggest such talks will be a major challenge to both parties, to put it…diplomatically.